Business

Intensifying efforts in developing derivatives

Developing derivatives will help to reduce the current problem of shallowness and lack of breadth in the capital market. CHRIS UGWU writes

On account of the economy’s radically changing financing needs, including recourse to public private partnership (PPP) arrangement as a solution to the nation’s infrastructure crisis, finance experts are of the opinion that opportunities should now abound for broadening the exchange’s product offerings to include key derivative categories, expansion of listed mutual funds, index funds, among others. According to reports, the derivatives market continues to be the largest single segment of the global financial market and has been estimated to be more than five times larger than global equity and bond markets.

Local and international players in the derivatives market space, therefore, continue to anticipate the launch of ETDs in the market and are keeping a keen eye on the activities of NGX in this regard. In an effort to strengthen the Nigerian capital market and make it compete favourably with other exchanges across the globe, some experts have, in various fora, called on the regulators to create more products that would broaden deepen and inject liquidity to the market. In pursuit of its drive to deepen the stock market, the regulators have said it would intensify efforts to create more products like derivatives to offer investors other alternative investment platforms.

What are derivatives?

A derivative is a contract between two or more parties whose value is based on an agreed-upon underlying financial asset, index or security. Common underlying instruments include bonds, commodities, currencies, interest rates, market indexes and stocks, according to Invetopedia. Futures contracts, forward contracts, options, swaps and warrants are common derivatives.

A futures contract, for example, is a derivative because its value is affected by the performance of the underlying contract. Similarly, a stock option is a derivative because its value is “derived” from that of the underlying stock. Derivatives are used for speculating and hedging purposes.

Speculators seek to profit from changing prices in the underlying asset, index or security. For example, a trader may attempt to profit from an anticipated drop in an index’s price by selling (or going “short”) the related futures contract. Derivatives used as a hedge allow the risks associated with the underlying asset’s price to be transferred between the parties involved in the contract. Commodity derivatives are used by farmers and millers to provide a degree of “insurance.” The farmer enters the contract to lock in an acceptable price for the commodity; the miller enters the contract to lock in a guaranteed supply of the commodity. Although, both the farmer and the miller have reduced risk by hedging, both remain exposed to the risks that prices will change.

For example, while the farmer locks in a specified price for the commodity, prices could rise (due to, for instance, reduced supply because of weather-related events) and the farmer will end up losing any additional income that could have been earned. Likewise, prices for the commodity could drop and the miller will have to pay more for the commodity than he otherwise would have. The basic principle behind a derivative contract is to earn profits by speculating on the value of the underlying asset at a future date.

As such, derivatives are used as a risk management instrument, and are suited to both professional and private investors who wish to hedge an open position or gain exposure to assets and markets without necessarily holding the underlying assets. ETDs are variants of derivatives traded on an organised securities exchange as against those other derivatives traded through informal over-the-counter (OTC) market. The derivatives market, however, is the financial market for derivatives, financial instruments like futures contracts or options, which are derived from other forms of assets. The market can be divided into two, that for exchange-traded derivatives and that for over-the-counter derivatives.

SEC approves 7 NGX’s-traded derivatives

Nigerian Exchange Limited (NGX) recently announced that it received approval for seven derivatives contracts from the Securities and Exchange Commission (SEC). The approved contracts, according to NGX, are Access Bank Plc Stock Futures, Dangote Cement Plc Stock Futures, Guaran-ty Trust Bank Plc Stock Futures, MTN Nigeria Communications Plc Stock Futures, Zenith Bank Plc Stock Futures, NGX 30 Index Futures and NGX Pension Index Futures. This announcement follows the successful registration of NG Clearing by SEC, as a premier Central Counterparty, effective 7 June 2021. With these approvals, NGX is inching closer to launch West-Africa’s first Exchange Traded Derivatives supported by NG Clearing in the risk management process. Ahead of the launch of derivatives, the Chief Executive Officer, NGX, Mr. Temi Popoola, noted: “The launch of the derivatives market aligns with our commitment to build a market that thrives on innovation and responds to the needs of stakeholders in accessing and using capital. We are, therefore, excited about the prospects of deepening Africa’s position in the global financial markets through ETDs, as well as enhancing liquidity and mitigating against price, duration and other financial risks that may arise from sophisticated financial transactional activities.” Leading up to the launch of ETDs in the market, NGX has continued to ensure widespread understanding of derivatives, its applicability and how investors can reap maximum value from the asset class. NGX has collaborated with both local and international organisations such as SEC, JPMorgan Chase, CBOE Options Institute, and NG Clearing to facilitate in-depth capacity building programme on the derivatives market. In addition, through its learning and development arm, XAcademy, NGX has hosted trainings to prepare capital market players who wish to undertake the Chartered Institute for Securities & Investment UK Global Derivatives qualification exam, and is on track to host further trainings for other stakeholders in the near term.

Launching derivatives trading

Following the approval in principle received by NG Clearing Limited from SEC to launch clearing and settlement of exchange traded derivatives products, as Nigeria’s premier Central Counterparty Clearing House (CCP), NGX said recently that it had intensified engagements with stakeholders as it look forward to launch its first derivatives product in 2021. The NGX boss, Mr. Oscar Onyema, recently said: “We are working tirelessly to ensure that our Derivatives market remains aligned with International Organization of Securities Commission (IOSCO) principles by facilitating access to recognized and licensed derivative products, world class market surveillance technology, effective trading rules as well as appropriate risk management and clearing facilities.”

Engaging trading licence holders

As Nigerian Exchange (NGX) Limited inches closer to the launch of Exchange Traded Derivatives (ETDs) in the Nigerian capital market, it continues to engage with the capital market ecosystem. In collaboration with NG Clearing (NGCL), NGX recently hosted an engagement session with trading license holders (TLHs). Speaking at the session, the Divisional Head, Trading Business, NGX, Mr. Jude Chiemeka, noted: “NGX, in its quest to be Africa’s preferred exchange hub, recognises the importance of a welldeveloped derivatives market and has worked assiduously to build the regulatory and technology framework and competence required to support the launch of a standardised ETDs market. “We are confident that the derivatives market will complement existing cash markets and provide investors and other market players with the necessary tools for tactical asset allocation, risk management and cost management for effective portfolio management. Our adoption of a best in class central counterparty and clearing house, NG Clearing, further engenders confidence in the ETD market segment amongst market participants, as the clearing infrastructure being set-up will be of international standards capable of reducing systemic risk and enhancing market transparency.” During the session, the Head, Derivatives Markets, NGX, Mrs. Chidinma Chukwueke-Okolo, provided TLHs with information on their roles, as well as the minimum operating standards for participating in the derivatives market. Areas where TLHs must show competence are manpower and equipment, organisational structure and governance, effective processes, global competitiveness and technology. The Chief Operating Officer, NGCL, Mr. Ayokunle Adaralegbe, also shared insights into the approach to clearing in the derivatives market.

Last line

Derivatives are essential in markets with a significant low product to investor ratio like the Nigerian Exchange Limited. However, the regulators and fund managers have key roles to play in ensuring the right products are introduced into the market and that product proliferation does not lead to investment abuse.

 

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